Learning Objectives
- Define accounting and explain the differences between managerial accounting and financial accounting.
- Identify some of the users of accounting information and explain how they use it.
- Explain the function of the income statement.
- Explain the function of the balance sheet.
- Calculate a break-even point given the necessary information.
- Evaluate a company’s performance using financial statements and ratio analysis.
Apple Inc. is the most valuable company in the world. This statement is based on market value, which in August 2020 was roughly $1.9 trillion.[1] Although markets can fluctuate, sometimes wildly, if you are reading this chapter for a course only months later, it is unclear whether Apple will have retained or ceded its leadership position to Microsoft, which has taken the leadership position multiple times since 2018.
You may wonder what kind of information is used to make these determinations. How does the market know that Apple should be valued more than $400 billion higher than Microsoft, for example?[2] Do investors just make their decisions on instinct? Well, some do, but it’s not a formula for sustained success. In most cases, in deciding how much to pay for a company, investors rely on published accounting and financial information released by publicly-traded companies. This chapter will introduce you to the subject of accounting and financial information so you can begin to get an understanding for how the valuation process works.
The Role of Accounting
Accounting is often called “the language of business” because it communicates so much of the information that owners, managers, and investors need to evaluate a company’s financial performance. These people are stakeholders in the business—they’re interested in its activities because they’re affected by them. The financial futures of owners and other investors may depend heavily on strong financial performance from the business, and when performance is poor, managers may be replaced or laid off in a downsizing. In fact, a key purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. You shouldn’t try to run an organization or make investment decisions without accurate and timely financial information, and it is the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we’re now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information,